Value Traps: How To Spot And Avoid Them By Answering 10 Simple Questions

by: Lou Basenese

A perfect storm is brewing for investors to get burned …

How so? Well, the S&P 500 Index just put up another impressive quarter, rallying about 6%. Year-to-date, the Index is up almost 17%. And since the March 2009 bottom, it’s up over 110%.

Given such strong performance, investors are bound to start worrying that this bull market’s getting long in the tooth. When they do, they’ll start looking for undervalued gems – stocks that, for one reason or another, got unfairly left behind and still have plenty of room to rally.

While I can’t bemoan the practice of hunting for assets at bargain prices, sometimes stocks are cheap because they actually deserve to be cheap. For some, cheapness is a way station before heading on to bankruptcy.

In other words, there are value stocks and value traps

A value stock is a beaten-down company that’s cheap compared to its earnings, its competitors and/or some other relevant benchmark that’s poised for a turnaround.

Conversely, a value trap is a beaten-down company that’s cheap compared to its earnings, its competitors and/or some other relevant benchmark that’s poised to never quite turn around.

Obviously, we want to avoid the latter like the plague. But doing so requires some extra work. Of course, I’m sure you’ll agree that keeping your capital out of harm’s way justifies the extra effort.

So, before you go bargain hunting in this market, arm yourself with this list. It could be your only chance to avoid getting snared in a value trap …

#1: Is there a near-term catalyst? First thing’s first, if there’s nothing on the horizon – like a new product launch, key marketing arrangement, a shake-up of the executives, the conversion of a massive order backlog, etc. – we shouldn’t bother. Companies and stocks need catalysts in order to advance. If none exist in the next 12 to 18 months, chances are the stock will be stuck in neutral – or worse, reverse.

#2: What are insiders doing? Nobody knows the company – and its future prospects – better than the insiders. If they’re not salivating over the “cheap” prices and backing up the truck, we shouldn’t either.

#3: Is the company addicted to debt? Too much debt magnifies the impact of tough times. As sales decrease, interest payments take up more and more of the company’s earnings. Not to mention, unwinding leverage is a time-consuming process. So even if the company boasts new, fiscally responsible management, beware. Or as Warren Buffett observes: “When a management with a reputation for brilliance takes on a business with a reputation for bad economics, it’s the reputation of the business that remains intact.”

#4: Does the dividend yield seem too good to be true? Value investors love to tout they “get paid to wait” for a turnaround. Granted, many stocks do maintain their dividends through a downturn. But countless others don’t. They slash or cancel them altogether, just to stay in business. No matter how tempting, tread carefully when the dividend yield hits double-digit levels.

#5: Is the company just as “cheap” based on the future? A company might appear dirt cheap based on its price-to-earnings (P/E) ratio. But don’t be fooled or get too easily excited. Remember, the P/E ratios cited on most financial websites are historical. And as investors, we don’t care what a company was worth… we care about what it will be worth. So before you buy, make sure the stock’s forward P/E ratio is similarly attractive.

#6: Which direction is the company’s marketshare headed? A general economic slowdown is one thing. But when a company’s losing marketshare, too, that’s an indication that a competitor has a better mousetrap. And while economic growth is cyclical, marketshare is not. So even if the economy or industry turns around, chances are the company’s marketshare won’t.

#7: Does the company operate in a highly cyclical or moribund industry? If you go hunting in a highly cyclical industry (like semiconductors) you’re asking for trouble. The same goes for industries destined for obsolescence (like print media). To win with these stocks, you need both the misfortunes of the company and the industry to reverse course. We should stack the odds in our favor when we invest, not start off with an uphill battle.

#8: How’s the free cash flow? Earnings can be massaged, manipulated or completely fabricated. But cash cannot. So make sure free cash flow is stable or growing. If nothing less, it provides management with a little wiggle room when considering ways to speed up a turnaround.

#9: Is the stock liquid enough? Just like insiders provide support to share prices, so do institutions like mutual funds, pension plans, hedge funds, etc. Both groups can move stock prices quickly and significantly. However, many institutions can’t (or won’t) buy stocks trading for less than $10, with a market cap below $1 billion, or stocks that don’t trade several million dollars’ worth of shares each day. Without the potential for institutional ownership, a quick rebound in prices becomes less likely.

#10: Does the company have a sustainable competitive advantage? For a stock to rebound, we need the company to thrive, not just survive. That’s not possible without a sustainable competitive advantage. So stick to companies that are light years ahead of the competition in terms of design, marketshare, new product offerings and/or technology.

Bottom line: Don’t kid yourself. Detecting a value trap is no easy task. Even the best investors occasionally get snared. Think Bill Miller with Countrywide and Freddie Mac, and Carl Icahn with Yahoo! (YHOO). But these 10 questions should help limit the frequency of your missteps.

At the very least, they’ll ensure you never buy based on price alone.